Company directors have a fiduciary duty to act in good faith in the best interests of the company when exercising their powers and discharging their duties.  It is settled law that, among other considerations, this requires directors to specifically consider the interests of their particular company (as opposed to the corporate group as a whole).  This is sometimes referred to as the “entity” approach.

In practice, larger businesses tend to operate using a corporate group structure (consisting of a holding company and subsidiaries), rather than carrying on the business(es) in a single entity.  This may be for a range of reasons including asset protection, limitation of liability, investment structuring and tax effectiveness.

In the context of directors’ duties, a corporate group structure raises the question of whether a director of a company (“Company A”) may have regard to the interests of other related companies in the broader corporate group.  Specifically, can a director do this without breaching the duty to act in the best interests of Company A, in accordance with the “entity” approach.

The issue often arises in relation to upstream intra-group transactions.  For example, where a subsidiary (“Subsidiary A”) guarantees an obligation of another subsidiary in the group (“Subsidiary B”) with no commercial benefit being derived by Subsidiary A.  In contrast, where a parent company guarantee is given (i.e. a downstream intra-group transaction), the issue may not arise (e.g. because a benefit may be realised by the guarantor parent company by way of a future dividend paid to it by the subsidiary).

Directors should always exercise caution in relation to upstream intra-group transactions.  It is best practice to seek appropriate legal advice and to properly document the decision (including reasons and the commercial benefit to the company) in the company records.

Corporate groups will often have common directors for the different entities within a corporate group.  Individual directors must “change hats” for each different company in the group and make decisions separately each time as a director of the relevant company board.

In practice, company directors come under pressure to act in the interests of the corporate group as a whole, rather than considering the interests of each particular company (provided the action would still reasonably be in the interests of the particular company).  This approach is generally referred to as the “enterprise” approach.

Although Australian law on directors’ duties in a corporate group is based on an entity approach and principles, the Corporations Act 2001 (Cth) (the Act) provides some scope for adopting an enterprise approach, but only in limited circumstances.

Section 187 of the Act allows a director of a subsidiary to consider the interests of the corporate group in limited circumstances.  The provision was introduced by the Corporate Law Economic Reform Program Act 1999 (Cth) and at the time, the explanatory memorandum referenced:

“permit[ting] directors who serve on wholly owned subsidiaries to take into account the interests raised by the nominating company”, to clarify “the issue of conflict of interest faced by directors where they are a director of two or more companies.”[1]

Notably, this section only applies to wholly-owned subsidiaries and in circumstances where solvency is not an issue.  The test for whether a director acted in good faith in the best interests of the holding company is an objective test, meaning directors must act “reasonably”.  The company constitution must also expressly authorise the directors to act in the best interests of the holding company for section 187 of the Act to apply.

Directors of subsidiary companies should instruct a lawyer to review the company constitution(s) to ensure they include an appropriate provision enlivening section 187 and confirming the express authorisation.

To meet the definition of a ‘wholly owned subsidiary’ of a body corporate (Holding Company) all of the members (shareholders) of the subsidiary must be either the Holding Company itself (or its nominee) or another wholly owned subsidiary of the Holding Company (or its nominee) (see section 9 of the Act).

For corporate groups, this strict requirement of 100% share ownership influences decisions about structuring, both with respect to the corporate group itself and any specific inter-company or upstream transactions.  The need for a subsidiary to be wholly-owned before its directors can consider the interests of the holding company can often be overlooked, particularly in an incorporated joint venture or family company group context.

A typical incorporated joint venture is a structure where the participants (JV investors) arrange for the incorporation of a separate legal entity (company) to pursue an agreed business objective.  It is common for each JV investor (depending on their shareholding) to have the right to appoint one or more directors to the board of the JV company.  A company that is a joint venture will not be a wholly-owned subsidiary of an entity, meaning the nominee directors will not be able to rely on section 187 of the Act if they adopt an enterprise approach.

JV directors must be aware that their duty to act in good faith in the best interests of the JV company is independent of their interests in the JV investor.  When a director is making decisions at the JV company level, they should not prioritise the interests of the JV investor, even where the purpose of the JV investor entering into the joint venture was to achieve a particular benefit for itself.

All JV directors must take the time to ensure they are aware of what is required to satisfy their directors’ duties, including the duty to act in good faith and the best interests of the company when acting as a JV director.  This is critical in the family group context, as the role of a JV director gives rise to very real issues when a private company takes shares and a board position in a JV company.

The concepts in this short article are complex and need to be considered in the context of the specific facts.  If you have any queries, please contact us for advice.  We regularly advise clients on structuring and can assist with implementing an appropriate structure for new business ventures with third parties.

[1] Explanatory Memorandum, Corporate Law Economic Reform Program Bill 1998 (Cth) 29 [6.17].